According to the Wall Street Journal (WSJ), market manipulation through “pump and dump” schemes have become increasingly prevalent in cryptocurrency markets. This article provides an overview of pump and dump schemes, the WSJ findings and examines current and future regulatory responses.
What are Pump and Dump Schemes?
Pump and dump schemes are a well-known form of market manipulation of securities markets. The perpetrators of the scheme will attempt to boost the price of an investment through recommendations based on false, misleading or greatly exaggerated statements. Having already established a position in the investment, the perpetrators sell at the higher price leaving fooled investors with a significantly devaluing investment. Originally undertaken via cold calling in ‘boiler room’ call centers, the internet has opened up new means for market manipulations to spread mis-information including via online investor chat rooms.
Pump and dump schemes and similar strategies have been outlawed on securities markets since at least the 1930s. Market manipulators today risk criminal, civil and regulatory sanctions for engaging in pump and dump schemes. Nonetheless, pump and dump schemes proliferated during the dot-com boom pushed by ‘boiler room’ brokerages like Stratton Oakmont, founded by the “Wolf of Wall Street”, Jordan Belfort. Belfort pleaded guilty to charges of securities fraud and running pump and dumps affecting 34 companies and costing investors more than US$200 million in losses. Recently in the UK, six individuals subject to a Financial Conduct Authority (FCA) criminal prosecution were found guilty for their roles in a series of boiler rooms which led to the loss of more than £2.7 million of investors’ funds.
The challenge of cryptocurrency markets is that they remain predominantly unregulated worldwide. Typical market manipulation such as pump and dump schemes are therefore not subject to regulatory action. The distributed, anonymous, cryptographic and irreversible nature of the underlying blockchain technology of certain cryptocurrencies also presents particular challenges for taking action against manipulation.
WSJ analysis of trading data and online communications among traders between January and the end of July 2018 identified 175 ‘pump and dump’ schemes involving 121 different digital coins, which showed a sudden rise in price and an equally sudden fall minutes later. The WSJ estimated these schemes resulted in at least US$825 million in trading activity and hundreds of losses by legitimate investors.
The WSJ analysis examined “pump groups”, these are online chatrooms analogous to the boiler rooms of old. The largest pump group is Big Pump Signal, with more than 74,000 followers on the messaging app Telegram. The WSJ also noted that there are many private pump groups, accessible only by invitation, generally overseen by an anonymous moderator. Big Pump Signal’s strategy is to announce a date, time and exchange for a pump of typically illiquid cyptocurrency. As the buying frenzy pushes prices up, members of the pump group begin to sell at the signal. Successful traders frequently gloat about their profits. The WSJ noted one example where the price of an obscure coin called ‘cloakcoin’ was pumped – the price jumped 50% to US$5.77 before falling to almost a dollar in two minutes. In total, 6,700 trades worth US$1.7 million were executed – compared to virtually no trading the hour before.
Like most pump groups, Big Pump Signal’s operations are not transparent. The moderator is anonymous, ownership of an associated website is cloaked. The Journal’s attempts at contacting the moderator were unsuccessful. Members of pump groups are charged monthly fees and may also be required to evangelize the service for access to trading information. Of course, it is entirely possible that members of such groups are also being taken advantage of by the anonymous controllers with their own interests in various cyptocurrencies.
FCA Statements and Action
In this jurisdiction, the FCA issued a statement in April 2018 confirming that it does not consider cryptocurrencies themselves to be currencies or commodities under the second Markets in Financial Instruments Directive 2014/65/EU (MiFID II). This means the transfer, purchase and sale of cryptocurrencies, including the operation of a cryptocurrency exchange, all fall outside the FCA’s regulatory remit. Accordingly, the typical pump and dump schemes identified by the WSJ would not appear to be actionable by the FCA at this time.
In its April statement, the FCA reminded firms, however, that instruments which use the token or coin as a reference value, such as futures, Contracts for Difference (CFDs), options or other derivatives, are capable of being captured as a financial instruments under MiFID II and UK legislation. As a result, activities such as dealing in, arranging transactions in or advising on such derivative instruments would require authorisation by the FCA in accordance with the existing legislative and regulatory framework. In May 2018, the FCA confirmed that it is investigating 24 businesses that deal with cryptocurrencies in the UK and has opened 7 whistleblower reports during 2018, considering whether the businesses in question might be carrying on regulated activities that require FCA authorisation without the appropriate licences.
More recently, the FCA published a statement on 27 June 2018 warning consumers about cryptocurrency investment scams. The FCA noted that fraudsters tend to advertise on social media often using the images of celebrities or well-known individuals to promote cryptocurrency investments. The ads then link to professional-looking websites. Consumers are then persuaded to make investments with the firm using either cryptocurrencies or traditional currencies. Consumers should be wary of advertisements online, cold calls or social media posts promising high returns on investments in cryptocurrencies or cryptocurrency-related products.
Regulatory inertia in the face of blatant manipulation of cyptocurrency markets such as pump and dump schemes is clearly unsatisfactory. Instead of an outright ban on the trading of cyptocurrencies, the Governor of the Bank of England, Mark Carney, has suggested that the better approach would be to “regulate elements of the crypto-asset ecosystem to combat illicit activities, promote market integrity, and protect the safety and soundness of the financial system”.
One such method would be to bring cryptocurrency wallets and exchanges into the regulatory perimeter. Already subject to money laundering regulations, regulated cryptocurrency exchanges could be required to have in place volatility control mechanisms which do not permit dramatic price deviations away from the last traded price during a cooling-off period. Typical amongst securities exchanges, such mechanisms could effectively dampen the ability of manipulators to pump and dump markets.
One UK cryptocurrency exchange has already voluntarily sought and obtained regulatory authorisation. In March 2018, Coinbase obtained authorisation by the FCA as an Electronic Money Institution. Whilst the authorisation does not cover cryptocurrency trading, it has given Coinbase enough legitimacy to partner with Barclays. Through this partnership, Coinbase now has access to the UK’s Faster Payments System, enabling UK customers to directly use sterling to buy and sell cryptocurrencies, without the need for an international bank transfer.
The UK parliament’s Treasury Committee has launched an inquiry into digital currencies and the distributed ledger technology. In its response to the inquiry, the FCA has said it would “continue to monitor the appropriateness of the existing regulatory framework”. The outcome of this Parliamentary inquiry is eagerly anticipated.